If the objective of the RBI’s shock-and-awe hike in short-term interest rates and liquidity squeeze on 15 July was to anchor currency expectations, it isn’t obvious these are realized. The rupee has steadied below Rs.59 as RBI intervention gained effectiveness from these measures, but currency expectations aren’t quite anchored. Exporters, for example, haven’t begun to realize dollar proceeds, believing they have nothing to lose; speculative trading in currency derivatives, where most bets were located anyway, reportedly continues as the stock market regulator resists making this costlier; while markets continue to expect the rupee to depreciate further after a short respite.

Worse, the RBI is chasing its own tail as it juggles between managing exchange rate and interest rate expectations and trying to invert the yield curve, which stubbornly slopes upwards instead. The ludicrousness of the idea—that interest rates at the short end can be raised without touching the policy rate—was so quickly exposed it would be laughable if the economy wasn’t so weak: The RBI embarrassingly failed to even conduct the second leg of these measures—Rs.120 billion of open market operations to increase rupee demand—as investors demanded higher yields; eventually, it capitulated somewhat by accepting a more than 50 bps increase in the 10-year benchmark yield last Friday, after a three-day stand-off in which an auction was called off and another partially devolved. With the RBI unable to squeeze rupee liquidity hard enough, the overnight, or call rate, which shot to 8.53% (from 7.21%) on 16 July, has fallen equally as fast and mortifyingly, below the policy rate.

This questions whether the defence can sustain without a complementary increase in the policy-rate. Since even the PM stated the policy rate isn’t raised, nicely locking up the RBI, the flip-flop has to continue with the central bank possibly looking at other ways to tighten, e.g. increase cash reserve requirements for banks or lower government spending. That banks hold more securities than statutorily needed (30.14% vis-à-vis 23%) and loan demand is very weak (the incremental credit-deposit ratio was 45%, end-June) only complicates RBI’s task some more.

An exit at this point would seriously erode credibility, indicating the situation has to continue until the currency is sufficiently stabilized in policymakers’ view. There is enormous uncertainty on how long this ‘temporary’ phase can be, for the gamble is predicated upon improvements in the current account deficit and financing reassurance. To that end, the RBI streamlined gold import norms yesterday, while the government is reported to examine import-compression measures. But reports of mobilizing overseas funds by either a sovereign bond issue or from non-resident Indians by offering them higher interest rates on their deposits, if true, are incredulous in the context of the interest-rate defence: if this route had to be taken, where was the need for this sledgehammer?

An exit, now or whenever policymakers consider appropriate isn’t going to be easy in view of credibility issues and that market beliefs will be tested then. Seeing the collateral damages—scaled down growth forecasts, higher bond-yields, increased market volatility, stoppage of corporate bond and deposit issuances, caution from the only rating agency to not have lowered India’s credit-rating so far as well as increased downgrade risk and an adverse, sea-change in the macro environment—one hopes the move doesn’t drive the economy further into the abyss.